Pension returns

Yet most public pension funds in California and across the nation are forecasting much higher annual returns than that for their investment portfolios.

CalPERS, the California State Teachers’ Retirement System (CalSTRS) and the University of California Retirement Plan are predicting average annual returns of 7.5 percent over 20 years. The city of San Diego has the same forecast.

Given the slump in stocks and low interest rates and bond yields, are these public pension fund return assumptions realistic?

A number of pension experts have begun arguing for a more conservative outlook. Joe Nation, a public policy professor at Stanford University and a critic of the assumptions used by the big California public pension plans, has advocated for a 6.2 percent long-term return target based on a blended stock and bond portfolio.

Using a predictive computer model, Nation said there’s a 1 in 3 chance CalPERS will hit its current 7.5 percent average annual return forecast over the next 20 years, “which of course means there is a 2 in 3 chance you’ll fall short.”

Bradley Belt, former chief executive of the federally chartered Pension Benefits Guaranty Corp., which provides benefit insurance for corporate pensions, said public pension funds “are significantly higher in their return assumptions than is the case in private sector pension plans.

“Nobody knows what returns will be,” added Belt, now senior managing director of the Milken Institute. “But nonetheless, the expectation and conventional wisdom is actual returns will be lower over the next 10 to 20 years than has been the case historically.”

Why does long-term investment performance matter? In essence, projected returns are part of the calculation for the tax dollars that financially strapped government employers must set aside to cover promised pension benefits. Higher investment returns mean less tax dollars need to flow toward pension benefits. Lower returns mean more tax dollars must go toward benefits instead of paying for government services.

The issue is getting attention now because many pension plans are not 100 percent funded, meaning the money in the plan is unlikely to grow enough over time to meet the full promised benefits to current employees and retirees.

“If you only earn 5.5 percent as opposed to the assumed 7.5 percent, you can get in trouble really quickly,” said Nation, the Stanford professor. “And they’re already underfunded.”

For their fiscal year ended June 30, CalPERS, the city of San Diego and some others did not hit that 7.5 percent target. CalPERS estimates returns of about 1 percent, and San Diego is at less than 1 percent.

The fund managers blame poor market conditions this past year. But they point out that an occasional bad year does not signal a trend.

For example, CalPERS rang up a 21 percent gain in fiscal 2011 and said it has regularly outperformed its 7.5 percent average annual return target, beating the goal 13 times in the past 19 years. Looking back at 30-year annual investment return averages, CalPERS says it exceeds 9 percent.

“You have to always keep in mind were talking about the long term,” said Edd Fong, a CalPERS spokesman. “Any one year can be spectacular or pretty dismal just like your 401(k). But over the course of a 10-year or 20-year period, you hope it would be on the plus side — and nicely so.”

Moreover, big pension funds aren’t invested solely in U.S. stocks and low yield bonds. They put money to work in a wide range of assets, including real estate, private equity funds, global stocks and other investments that historically offer better returns.

CalPERS looks at inflation and historical data, as well as working with actuaries, to come up with an expected future rate of return. “We’re not just throwing darts,” said Fong. “We do go through a thorough technical analysis.”

CalPERS had its assumed rate of return set at 7.75 percent until setting a new benchmark earlier this year at 7.5 percent. That didn’t go as far — 7.25 percent — as its chief actuary recommended.

Correction

A previous version of this story had an incorrect number for the increase in the state's pension costs. It was $303 million.

The change increased the state’s annual pension bill by $303 million a year, to $3.7 billion.

Dating back to 1926, blue chip U.S. stocks on the Standard & Poor’s 500 index have produced an average annual return of just under 10 percent, said Charles Rother, chief investment strategist with American Strategic Capital in Orange County.

Rother has run computer models “that are telling us a story of about average returns for equities” over the next decade. Among the reasons Rother is bullish on stocks include high quality corporate earnings, global economic growth, a flight to stocks from low-yield bonds and low credit costs for businesses.

“That surprises people,” he said. “We have been tainted by this experience of virtually no returns for 12 years now.”